High Quality, High Fees

Investors have plenty of options when it comes to dividend exchange-traded funds. These funds follow a variety of strategies: Some focus on high income, some on total return, others on quality, and some focus on a combination of all three. One interesting choice is First Trust Value Line Dividend IndexFVD, a low-volatility dividend strategy ETF that uses proprietary research by Value Line to construct its portfolio. Although "dividend" is in the fund's name, its most attractive qualities are its relative stability, emphasis on quality stocks, and significant value tilt. It was one of the very first dividend ETFs to hit the market, and its strategy has performed very well over the years (its historical performance was good enough to win it a 5-star Morningstar rating)--but its 0.70% expense ratio, a relic of the days before the ETF price wars, is the highest among dividend ETFs today. That fee may have been excusable when FVD launched 10 years ago, but today such a price tag is unjustifiable when investors can buy similar ETFs for just a few basis points a year. FVD's strategy is worth close consideration, but investors must consider whether it's worth the price tag.

Why DividendsThere's a lot to recommend dividend investing. By paying a dividend, companies let investors share in their growth: Dividends are paid from a firm's free cash flow, making a consistent and steadily increasing dividend a good indication of a company's strong financial health. Over the long term, dividend-paying stocks tend to outperform non-dividend-paying stocks, and with less volatility because of the compounding effect of dividends on total return. The effect is particularly strong during bear markets, when dividend income can cushion a decline in price. During the past five years, FVD's index captured only 77% of the S&P 500's downside compared with 87% of its upside. Dividends are also the primary driver of historical stock returns. After adjusting for inflation, dividend income has accounted for nearly 75% of annual U.S. stock market returns over the last century.

Looking Under the HoodFVD tracks the Value Line Dividend Index, which is an equally weighted index that uses proprietary Value Line research to select stocks for inclusion. First, constituents must receive a Value Line Safety Ranking of 1 or 2 out of 5. The Safety Ranking sorts stocks based on their price stability and financial strength relative to a universe of about 1,700 stocks. A rank of 1 or 2 indicates highest and above-average safety, respectively. The index next removes any stocks with a dividend yield lower than the indicated dividend yield of the S&P 500 and/or a market cap below $1 billion.

The resulting portfolio looks a lot like a low-volatility strategy that emphasizes yield. FVD's five-year standard deviation is one of the lowest among dividend ETFs and is even lower than that of dedicated minimum volatility ETFs. Many studies have shown that low-volatility stocks outperform high-volatility stocks in almost every market, and indeed, FVD's five-year Sharpe ratio (a measurement of risk-adjusted return) is high relative to other dividend ETFs. However, low-volatility stocks tend to lag during bull markets, as FVD did in 2013. It returned "only" 26.6% for the year, compared with the S&P 500's 32.4%. Low volatility is extremely valuable in market downturns, however: In 2008, FVD declined 24% compared with the S&P 500's 37% crash. Its quarterly distributions are also dependable, dropping only 16% in 2009.

FVD's construction rules also act as a quality screen. Fund company AQR has defined quality as a combination of growth, profitability, safety, and payout signals and have combined these traits to create a "quality minus junk" factor. To test whether FVD's index targeted quality firms historically, we can regress its monthly return on the Fama-French factors (more on this process here and here) and the quality minus junk factor. The four standard factors are the market return minus the risk-free rate (Mkt-RF), size (SMB), value (HML), and momentum (UMD).

Regression coefficients may seem complicated, but they are easy to interpret. If an ETF's loading on a particular is 0.50, for example, that means it is expected to return 0.50% if that factor increases by 1%. In the case of FVD, if quality stocks beat junk by 1%, it's expected to increase by 0.29%. These results show that over time, FVD has had significant exposure to quality stocks, which we like. Targeting the highest-yielding companies, as some dividend ETFs do, dilutes the benefits associated with a dividend strategy. Stocks usually provide high yield when their price has been lowered because of distress in the economy or in anticipation of bland earnings growth or a dividend cut. Too high a yield can also indicate the market's skepticism as to whether a payout is sustainable, and the market is usually right. Unsurprisingly, FVD's yield is only marginally higher than the S&P 500's. FVD yields 2.25% today, compared with SPDR S&P 500's SPY 1.80%.

The other factors here are also of interest. FVD also has a meaningful tilt to value stocks. In fact, its value loading is comparable to that of dedicated value ETFs. Its loading on market return, otherwise known as beta, is relatively low. The fund holds lower-beta stocks, which further quantifies its historical ability to hold up better than the S&P 500 during a crisis. All coefficients other than size were statistically significant at the 5% level.

Investing DefensivelyInvestors should also be aware that FVD is one of the most defensively tilted dividend strategy ETFs, with 51% of the portfolio in sectors like utilities (26%). Utilities, consumer defensive, and industrial stocks have generally been the fund's largest holdings in the past. That won't necessarily be the case forever, as the fund's sector holdings tend to shift over time. Financials once made up about 30% of the portfolio but declined through 2008 to their current 12% weighting.

The fund's defensive sector overweighting could prove a headwind if interest rates rise in the near future. When rates rise because the economy is growing at a healthy clip, defensive-sector stocks in particular become an expensive trade. The negative correlation between defensive-sector return and interest rates is notably damaging for utilities, which make up more than a fourth of FVD's holdings. These firms are heavily regulated, which severely reduces their ability to grow at the same rate as other equities during an economic boom.

Alternative ChoicesThere's no shortage of dividend ETFs for investors to choose from. Vanguard Dividend Appreciation ETFVIG charges 0.10% and selects stocks that have increased their dividends over the past 10 consecutive years. VIG has a quality tilt and conservative yield. Another offering from Vanguard is Vanguard High Dividend Yield Index ETFVYM, which also charges 0.10%. The fund sorts U.S. stocks by yield and market-weights its holdings. VYM is riskier than VIG but also yields slightly more.

Schwab U.S. Dividend Equity ETFSCHD is a relatively new fund but is the cheapest in the category at just 0.07%. SCHD's constituents must pass a variety of screens, including paying dividends for the past 10 consecutive years. Like VIG, SCHD has a quality tilt and low yield. This relatively young ETF has become a top pick.

SPDR S&P Dividend ETF's SDY screens are even more stringent, requiring firms to have increased dividends for the past consecutive 20 years. S&P overhauled the index in 2012 to reduce idiosyncratic risks and prevent this huge fund from moving the market. SDY charges a 0.35% expense ratio.

WisdomTree Equity IncomeDHS costs 0.38% a year and focuses more narrowly on dividend yield in its stock-selection process. Because it tilts to defensive sector stocks like utilities, DHS is sensitive to interest-rate changes. IShares Select Dividend ETFDVY is also heavy on defensive sector stocks. It selects companies that pass a variety of quality screens, and it requires constituents to have raised dividends for five years. DVY charges 0.40%, which is expensive.

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